The current rate environment presents plan sponsors with an unwelcome dilemma. The low level of interest rates makes matching liabilities and assets a very expensive exercise, whether in terms of the high upfront cost or in terms of the locking in of low yields-to-maturity. An alternative solution, which is used extensively in many corporate finance programs, is to invest (or issue, as may be the case) elsewhere and then manage the interest rate risk via swaptions. Why hasn’t this technology crossed from corporate asset management to the management of pension plans with a higher degree of frequency?
We believe that the answer is two-fold. First, until recently, asset/liability matching over small moves in interest rates has not been the focus of most pension plan investing programs and second, the unusually low interest rate environment has changed the relative attractiveness of purchasing bonds or swaps versus using an options hedge.
The key question for pension plans is how to hedge against upwards movements in rates when rates are at generational lows?
Swaptions are widely used, liquid and scalable instruments often used in the management and issuance of corporate debt. They are also a key part of managing interest rate risk for mortgage originators, insurance companies and other interest rate-sensitive entities.
Current market conditions are ideal for pension plans looking to hedge the duration of their liabilities using swaptions because downside protection can be purchased relatively cheaply today. The reason for this is that the term structure reflects expectations for an upward trend in rates since rate levels are at their lows. In fact, hedging costs are actually subsidized by these market expectations.
Source: Bloomberg, Mariner
The current pricing of swaptions is influenced mainly in two ways:
- The forward rate for any swap currently reflects expectations that spot rates are going to be higher in the future than they are now. What this means is that the market pays you (via the convergence of the forward to the spot) for taking the other side of the trade (the roll-down).
- Implied volatility has been relatively low across all asset classes and, furthermore, the swaption skew has for much of the recent past been very flat or even at times in favor of receivers (which are the swaptions typically used).
These two observations can be summarized simply that as expectations are for higher rates, the strategy of purchasing options to protect against lower rates is relatively cheap.
Working the math: Scenario Analysis
Since the hedging portfolio is not a linear function of rates, the best way to think about the portfolio is in terms of its performance in two different rate scenarios:
Case 1: Rates go down: the swaption tracks relatively closely to the swap
Case 2: Rates go up: expires worthless but loses far less than a swap
In both cases the cost to holding the swaption is that of the premium decay, theta, subsidized by the effect of the forward roll-down. Current static cost of holding swaptions is about 50-100bps per annum.
The use of swaptions in a hedging framework allows asymmetry in response to changing rates; that is, there is a loss of premium but no further capital losses if rates rise and protection increases as rates go down. To the right is a Monte Carlo simulation of the performance of a swaption portfolio versus one hedged by swaps. As you can see, the swaption portfolio substantially outperforms in a rising rate environment. Like any hedging portfolio, the swaptions need to be actively managed in response to market conditions; in our experience we have traded parts of the hedge about three times a year.
Paying for the swaptions
While most fixed income investors as well as actuaries agree that swaptions have a more desirable risk profile, the quick criticism is that they are “too expensive”. As shown above, it is not unreasonable to expect that this preferable type of risk and return profile will cost between 50 and 100 basis points per year. We believe that there are investment opportunities which can be easily coupled with a swaptions program to cover the costs and be competitive with a traditional LDI approach. Remember that you are only paying for the premium of the swaptions and you do not need to hold cash ready for margin (an unacknowledged cost of swap hedging) which makes the addition of a diversified and low market-exposure alpha program practical and potentially additive to portfolio returns.
Interest rates and swap rates remain at a generational low, close to the zero interest rate bound. In the long run, the likely path of rates is to the upside. Using either cash bonds or swaps means that the asset portfolio is going to experience broadly similar losses as the liabilities in a rising rate environment. However, hedging using swaptions will mean both that the asset portfolio retains flexibility to access a wide range of risk premiums while systematically outperforming the liabilities in a rising rate environment. This improves funded status without relying on risky macro allocation calls or underlying manager skill.
 This expectation is more properly embedded in the steepness of the short end of the yield curve (relative to the long end) and via arbitrage relationships is transmitted to the forward rate.
Ronan Cosgrave, CFA, CQF is a Managing Director in Portfolio Management. He serves as the LDI Portfolio Manager. Ronan is also a member of the firm’s Investment Oversight and Risk Management Committees. Ronan received his MBA from Columbia Business School, and B. Eng. in Chemical and Process Engineering (Honors) from Cork Institute of Technology.
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